Financing Prosperity
Ross Levine
University of California, Berkeley
3 Questions
① Does the functioning of the banking system influence long-run economic prosperity?
▫ Economic growth.
▫ Poverty & income inequality
Note: I will focus on the long-run, not on crises and business cycle fluctuations.
3 Questions
① Does the functioning of the banking system influence long-run economic prosperity?
②What regulations foster well-functioning banking systems?
▫ I will focus on regulatory strategies.
▫ I will not focus on details in the presentation.
▫ I will not focus on legal, political, & other determinants.
3 Questions
① Does the functioning of the banking system influence long-run economic prosperity?
②What regulations foster well-functioning banking systems?
③ Is Chile different?
▫ Besides torta mil hojas, cuchufli, etc.
▫ Are Chile’s banks important for prosperity?
▫ What bank regulatory challenges face Chile?
Does the functioning of the banking system influence long-run economic growth, poverty, and the distribution of income?
The debate: Casino view
Financial markets are unproductive casinos, where the rich come to place their bets.
▫ If they win, people lose.
▫ If they lose, people still lose.
➢Regulations should protect people from them.
This view is popular in
Hollywood
It is also popular at regulatory agencies,
international institutions, & within academia
The casino view:
▫ The fundamental determinants of prosperity are savings, education, and innovation.
▫ Finance plays little role in shaping these determinants.
▫ Finance’s bigger role is in shaping fragility.
➢Protect the economy from financial crises
The debate: Banks are essential view
• Banks shape economic horizons.
• “The banker authorizes the entrepreneur in the name of society to innovate.” Schumpeter (1912)
Essential view:Banks shape how well an economy …
• Mobilizes savings for “immense” works.
• Allocates capital to those with the best entrepreneurial ideas, rather than to those with most wealth & connections.
• Exerts sound governance over the use of that capital.
• Provides mechanisms to manage risk.
Thus, the essential view argues that
banks, and bank regulations can …
• Accelerate growth.
▫ Ease credit constraints and facilitate entrepreneurship.
▫ Enhance resource allocation and innovation.
• Disproportionately help the poor.
▫ Loosen links between access to credit and wealth.
▫ Increase the dynamism of labor markets.
Does the functioning of the banking system influence long-run economic growth, poverty, and the distribution of income?
Evidence?
Cross-country regressions
• Y = either economic growth, growth of income inequality, the income of the poor, extreme poverty.
• F = Measure of financial development.
• X1 … Xn = control variables, such as the level of GDP per capita, education, inflation, deficits, black market exchange rate premia, openness to trade, revolutions and coups, political assassinations, etc.
• Then, I graph the resultant relationship between Y and F: β
• Over the same period, 1960-2005 data permitting.
Finance and growth
Finance and inequality growth
ARG
AUS
AUT
BEL
BGD
BOL
BRA
CAN
CHE
CHL
CMR
COLCRI
DNK
DOM
ECU
EGYESP
FIN FRA
GBR
GHA
GRC
GTM
HKG
HND
HUN IDNIND
IRL
IRN
ITA
JAM JORJPN
KOR
LKA
LSO
MEX
MUS
MYS NER
NLD
NORNPL
NZL
PAK
PAN
PER
PHL
PRT
SEN
SLE
SLV
SWE
THATTO
TUN
TURTZA
URYUSA
VEN
ZMB
-.0
2-.
01
0
.01
.02
Gro
wth
in
the
log
of th
e G
ini C
oeffic
ient
-2.5 -2 -1.5 -1 -.5 0The Partial Component of The log Private Credit
Note: This suggests that finance is disproportionately good for lower income households. Not a trickle down story.
Finance and the incomes of the poor
ARGAUS
AUT
BEL
BGD
BOL
BRACAN
CHE
CHL
CMR
COL
CRI
DNKDOM
ECU
EGY
ESP
FIN FRA
GBR
GHA
GRC
GTM
HKG
HND
HUN
IDN
IND
IRL
IRN
ITA
JAMJOR
JPN
KOR
LKA
LSO
MEXMUS
MYSNER
NLD
NOR
NPL
NZL
PAK
PAN
PER
PHL
PRT
SEN
SLE
SLV
SWE
THA
TTO
TUNTURTZA
URY
USA
VEN
ZMB
-.0
4-.
02
0
.02
.04
Th
e P
art
ial C
om
po
ne
nt of G
row
th in T
he L
ow
est In
co
me S
ha
re
-2.5 -2 -1.5 -1 -.5 0The Partial Component of The log Private Credit
Finance and extreme poverty
DZA
BGD
BOL
BWA
BRA
CMR
CHL
COL
CRI
DOM
ECU
EGY
SLV
GMB
GHA
GTM
GUY
HND
HUNIDN
IRNJAM
KEN
LSO
MWI
MYS
MLI
MRT
MEX
NPL
NICNER
PAK
PAN
PRY
PER
PHL
POL
RWA
SEN
LKA
THA
TTO
TUN
TUR
UGA
URY
VEN
ZMB
ZWE
-.2
-.1
0.1
Th
e P
art
ial C
om
po
ne
nt of G
row
th in H
ead
co
un
t
-3 -2.5 -2 -1.5 -1 -.5The Partial Component of The log Private Credit
Remember why?
➢ Let’s conduct a “quasi-natural” experiment
➢ We will examine a policy change than improved banks in the different states of the United States in different years.
➢ Then, we can assess the effect of this “treatment” on outcomes.
A little history
• From the 1800s – 1995, U.S. states controlled:
▫ New banking licenses.
▫ Branching.
▫ Entry of banks from other states.
• They sold local banking monopolies.
▫ States sold banking licenses to banks.
▫ States protected those banks from competition.
A little more history
• This produced LOTS of banks: ≈30,000 banks! But, little competition.
• Produced a rich constituency for keeping those regulatory protections.
The end of history
• What changed? Was it a recognition of the inefficiency of those regulatory protections?
➢No.
➢Technology changed.
Competition and state growth
log(GSP)st = α + β1D-10
st + β2D-9st + … + β25D+15
st + As +Bt + εst
Competition & state inequality
-.06
-.04
-.02
0
.02
.04
Perc
en
tag
e c
ha
ng
e
-10 -5 0 5 10 15Years relative to branch deregulation
log(Gini)st = α + β1D-10
st + β2D-9st + … + β25D+15
st + As +Bt + εst.
Competition and wage growth
• Yes.
• Well-functioning financial systems foster prosperity.
• Poorly-functioning banks stymie prosperity.
• Are synthetic credit default swaps really disproportionately good for the poor?
Are financial and technological
innovation linked?
• Initially, only local investors could monitor trains
• This restricted growth.
Financial and railroad innovations
• Then: Specialized banks emerge to screen /monitor
• New financial / accounting reports help.
This is a dynamic process …• Besides new financial institutions and accounting …
• New financial instrument were designed too, e.g., preferred stock, income bonds (contingent on railroad profitability),
• By providing a menu of securities, financiers expand interest.
Last word on trains …
• Without financial innovation, the technological development of trains would have been slower.
Financial and oceanic explorations …
▫ from from partnerships to the commenda, and
▫ from limited partnerships, to the joint stock company
Financial & technological innovation continues
From IT and venture capitalism …
… to bio-technologies
Financial & technological innovation
A graphical illustration …
Technological innovation
level j
level j+1
Sector 1
• Entrepreneurs seek profits by innovating
• Success rate of innovation:• Property rights (profits)• Competition• Quality of innovator
Technological innovation + finance
level j
level j+1
Sector i
Finance
Better finance = better screening to find best innovator
But, is this complete?
• This ignores the VC and bio-tech story.
Technological innovation + static finance
level j
level j+1
Sector i
Thickness = screening quality
Finance
Technological innovation + static finance
level j
level j+1
Sector i Finance
level j+2
Screening quality diminishes as technology advances
level j+3
Technological innovation + static finance
level j
level j+1
Sector i Finance
level j+2
level j+3As technology advances, screening quality diminishes
Innovation rate slows
Technological innovation + static finance
level j
level j+1
Sector i Finance
level j+2
level j+3
Without financial innovation, technological innovation stops.
by financial entrepreneurs
Technological innovation + financial innovation
level j
level j+1
Sector i
level j+2
level j+3
level j
level j+2
level j+3
level j+1
Finance
Technological innovation + financial innovation
level j
level j+1
Sector i Finance
level j+2
level j+3
level j
level j+2
level j+3
level j+1
level j
level j+1
Sector i Finance
level j+2
level j+3
level j
level j+2
level j+3
level j+1
Financial and technological innovation
• Technological innovation makes “old” finance obsolete
➢Economic growth slows.
• Financial innovation makes “new” finance more effective
➢Facilitates technological innovation and boosts economic growth.
Monopolies slow technological & financial innovation.
• Yes.
• Well-functioning banks foster long-run prosperity.
• Poorly-functioning banks stymie long-run prosperity.
• Financial innovation is crucial for sustained technological innovation and hence economic growth.
• Of course, not all financial innovations foster long-run prosperity.
Regulatory strategies
① Competition
▫ Competition among banks spurs efficiency and improvements in financial services.
▫ Competition among banks spurs competition among nonfinancial firms, which enhances efficiency and technological innovation.
➢Opportunities flow increasingly to those with the best ideas and initiative.
Regulatory strategies
②Wariness of “strong” supervision & regulation
▫ Often stymie competition and financial innovations.
▫ Often distort the flow of credit toward political ends
▫ Often impede the funding of the most promising entrepreneurs.
➢ Official interventions in banking often lead to corruption, inefficiency, stagnation, and fragility.
Regulatory strategies
③ Transparency / incentives
▫ Regulations that enhance the private governance of banks work best:
Laws that force transparency
Credit bureaus, accounting systems
Legal rights & means for investors to exert governance
Regulatory strategies
③ Transparency / incentives
▫ Regulations that enhance the private governance of banks work best.
▫ Regulations that hinder the effective governance of banks work worst.
Implicit and explicit guarantees.
Official oversight implies official responsibility
Of course!
Banks and prosperity
• Chile looks very similar.
▫ Chile is not an outlier.
▫ Chile fits the estimates very closely.
➢Suggests that the bank-prosperity link is also very strong in Chile.
Bank, prosperity, and Chile
• Chile has been the most successful economy in Latin America over the last few decades.
▫ But: Growth slowed markedly over the last 5 years
Bank, prosperity, and Chile
• Compared to LA, Chile has well-developed banks
▫ Size: Credit / GDP
▫ Efficiency: net interest margins / overhead
▫ Inclusiveness: people accessing banks
• But:
▫ Looking beyond LA …
▫ Is it positioned to foster future improvements in long-run prosperity?
Regulations
• Competition
▫ Entry restrictions on foreign banks?
▫ Entry restrictions on the emergence of domestic banks?
▫ Other regulatory impediments to competition?
Regulations
• Competition
• Strong regulators
▫ Are they distorting the flow of credit?
▫ Are they limiting innovation?
▫ Are they raising the costs of doing banking?
▫ Are regulators well-governed themselves?
Regulations
• Competition
• Strong regulators
• Incentives / transparency
▫ How effective is the private governance of banks?
▫ Are regulations fostering or impeding governance?
▫ Do the legal and regulatory system facilitate the private governance of banks?
Concluding remarks
① The functioning of the banking system influences long-run economic prosperity
② Competition, a wariness of official regulation, and private governance improve banking
③ Chile faces similar challenges to other countries.